Gold’s run won’t be long-lived

By David Crisanti

The U.S. dollar price of gold has gone up every year since 2000. In that span late-night TV watchers have been treated to an increasing array of commercials that promote various companies’ interest in buying the viewer’s gold. In large cities hired hands roam the street wearing placards further advertising that willingness. CNBC guests tout gold as an essential part of any portfolio and its daily price movements are front page news.

The old saw that Joe Kennedy knew to sell all his stock ahead of the crash of ’29 when he heard his shoe shine boy giving market tips has long been moot during the current gold boom — gold and its virtues have been on shoe shine boys lips for well over half a decade, and yet still it rises.

During the current equity, commodity and bond market volatility gold goes up virtually every day. On days the stock market drops as investors rush to reduce risk, gold goes up as a ‘safe harbor’ or ‘flight to quality’ beneficiary. On days that markets rise, and investors are adding exposure, riskier currencies are bid up at the expense of the dollar, and gold goes up as a weak dollar play (any asset priced in dollars needs to appreciate when the dollar devalues if it is to maintain its intrinsic value, whether it be oil, copper, wheat, houses or cheese steaks). Further fueling gold’s price rise is that in an environment where interest rates are expected to remain low (the U.S. stated it is likely to keep its Fed funds rate near zero at least until mid-2013) an investment that pays no interest becomes relatively more attractive.

Any investment can be a good one, even a stake in a marginal venture, if the price is low enough. Conversely any investment, even in a fantastic asset can be a bad one if the price is high enough. Gold is a bad long term investment at today’s price.

Gold’s value stems from a two-fold belief that paper currencies are unreliable and the corollary that the yellow metal is the world’s only reliable currency. Underlying the former is the presumption that the guardians of paper currencies, central banks, can and will print more during deleveraging cycles (aka recessions) in an attempt to spread the losses incurred by profligate borrowers and lenders over the rest of the population. Printing more of a currency devalues it, helping those that owe it, and harming those that have saved it.

Regarding the unreliability of paper currency, history is on the side of the gold bugs. In every deleveraging since the Great Depression central banks have printed more currency. They have done so because economists generally believe it is in the best interest of the overall economy in the long run to spread the costs of a bust, and politicians find it easier to get reelected with policies that favor the majority (borrowers) rather than the minority (savers). This present deleveraging cycle, which began in 2008, is no exception as the Fed has engaged in a number of new programs that involve increasing the money supply, including the various Quantitative Easing programs, colloquially QE1, QE2, and (possibly) QE3.

Regarding the second pillar of faith among gold fanciers, that gold is and will remain a universally accepted unit of currency, history is less certain. It is true that gold could be an ideal currency because of its stable supply (the amount of new gold mined each year is equal to only 2% of the world’s supply, and perhaps as much as that amount falls out of circulation each year), relative transportability (all the world’s gold could fit in a sixty square foot cube), and its history as a unit of exchange dating back to 700 BC. But it has been several centuries since gold was commonly accepted as a unit of exchange, and has never been the world’s sole unit of exchange.

Equally important, even if gold were priced at parity to paper currency, the idea of gold as an actual currency is far from certain. In a scenario where paper currencies are devaluing as briskly as current gold prices indicate they might, in other words a quasi-anarchic period, people would be better served holding other stores of value such as grains or oil, that can actually be used to generate greater production. Gold has no industrial uses, and it is not entirely impossible that it would be bypassed as a form of exchange in favor of something that does.

Yet gold is priced today as if this viability as the world’s currency is a given, and then some. At today’s prices, all the gold in the world is worth twice as many dollars as all the currency in the world. If gold were everything its backers hope it to be, a true world currency, it can only ultimately be worth what all the world’s currencies are worth. An investor would be content to pay the current gold price of twice its current value ONLY if he believes that over time he will recoup that premium via paper currency devaluation ABOVE what he would have earned putting that paper in risk free investments.

In today’s extraordinary deleveraging environment, with historically low risk free rates of 3%, and money supply growing at approximately 10% a year, holding gold would net a 7% gain a year over paper. It would take (only) 10 years of compounding at 7% to make back the 100% premium paid today on gold—and then an extra 7% a year after that. However, over the long term (dating back to 1900) money growth and risk free rates have been roughly equal at 6%, which if we reverted to any time soon would mean a gold investor today would never recoup his premium.

This is not to say that the price of gold won’t go higher in the short run—sentiment can do incredible things to the price of an asset. In 1980, in the wake of the U.S. leaving the gold standard, and at the height of the last gold-as-a-currency mania, gold reached its peak of $850 an oz.– six times the value of all paper currencies at that time. Money supply would have needed to grow at 16% a year over the ensuing two decades for gold buyers to be whole versus earnings 6% a year on risk free paper money investments. However, money supply grew at only 6.5% a year killing gold-as-a-currency sentiment and by 2000 gold was trading at $250, which was only half the value of the world’s currencies.

In today’s day and age, when seemingly no one on TV, radio or internet questions gold as a currency, there is a collective amnesia that just eleven years ago the public and central banks alike were dumping gold, considering it as bogus a unit of exchange as ancient Greek multi-theism is a religion.

In the short run gold could go significantly higher, but in the long run, like Internet stocks and housing, it must ultimately revert towards its fair value–which given historic and current money supply growth rates, risk free interest rates, and gold’s questionable viability as a sole currency, is somewhere only slightly more than today’s supply of all the world’s currencies. This implies that a fair price is perhaps half the price it is today.

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